Are Residential Local Exchange Prices Too Low? Drivers to Competition in the Local Exchange Market and the Impact of Inefficiently-Set Prices

01 January 2000
By Dr. Karl McDermott et al.

Nearly five years after passage of the Telecommunications Act of 1996 ("the Act"), there is still widespread debate about the status and extent of competition in the local exchange market and whether the Act has succeeded or failed in one of its intended goals of fostering competition. While a consensus appears to have emerged that competition for large business customers in dense metropolitan areas is beginning to take hold, no such consensus exists for other types of customers. Specifically, policymakers are asking when they will begin to see a consensus emerge that competition is taking hold for:

:: Smaller business customers located in non-urban, rural areas; and
:: Residential customers.

There are plausible economic reasons why local exchange competition is developing in this manner.

However, there may be other valid reasons that help explain this pattern of local exchange competition. Specifically, are the policy-related features of local exchange markets-which may not be what one would find in undistorted competitive markets-having an impact? In this paper Dr. Ros and Dr. McDermott concentrate on a unique feature of local exchange markets. In the pursuit of universal service and fully exploiting the positive network externalities present in telecommunications, policymakers have historically priced residential network access below economic costs-i.e., lower than what one would find in competitive markets. The revenue sources that have historically been used to support residential prices include business services. While this policy has helped in permitting the United States to achieve high rates of telephone penetration, might it be distorting the development of local exchange competition and impeding competition for residential customers?

The purpose of this research is to test this hypothesis: are inefficiently set local exchange prices having an impact on the development of local exchange competition and inhibiting the development of residential competition? The paper attempts to find empirical evidence for this proposition and control for other factors that are impacting local exchange competition and identify major drivers and determinants of local exchange competition. Sections II and III provide a background on local competition and the economic predictors of local exchange competition. Section IV presents an econometric analysis.

This paper was published in Expanding Competition in Regulated Industries, edited by Michael Crew, Kluwer Academic Publishers, 2000.